Why Active Management Isn't as Dumb as You Think

Millions of investors have learned that if you can't beat the market indexes, you're better off joining them. The popularity of passive investment strategies has exploded higher with the rise of exchange-traded funds, most of which use formulaic criteria to choose their stock holdings rather than qualitative analysis.

Yet as valuable as low-cost index funds can be, some investors are too quick to dismiss all actively managed mutual funds as being a waste of money. In particular, if you focus too much on short-term results to justify abandoning active investing strategies, you could end up making the same mistakes as short-term traders who move in and out of stocks too quickly to capture the lion's share of their long-term gains.

Active managers fall short -- againS&P Dow Jones Indices recently did a study looking at the results of actively managed stock mutual funds. In particular, it looked at more than 700 mutual funds that finished in the top 25% in terms of one-year performance as of March 2011. After two years, fewer than 5% of those 700 funds managed to stay in the top 25% during each of the ensuing two 12-month periods.

Moreover, when S&P expanded the test to include managers in the top half, it produced similar results: Just 18% of funds in the top half by performance in 2011 managed to repeat those top-half returns in both 2012 and 2013. Looking back a longer period, only 2% to 5% of funds in various sub-asset classes managed to stay in the top half of performers for five consecutive years. Those figures are less even than a random distribution would predict, strongly suggesting that good performance in one period is more likely to be followed by worse performance in the next.

The wrong reason to go passiveYet judging mutual funds based on streaks of short-term performance is exactly the wrong way to evaluate a long-term fund's holdings. If you're committed to an investment strategy for the long haul, then occasional one-year underperformance shouldn't amount to anything.

Perhaps the best example of this phenomenon lately comes from Bruce Berkowitz, manager of the Fairholme Fund . In 2011, Berkowitz was coming off three straight years of having been among the top 10% of fund managers in the large-cap value category, earning himself an award as Morningstar's Fund Manager of the Decade for stocks. Yet in 2011, he made big bets on financial stocks that turned out to be far too early. Investments in Bank of America , mortgage- and bond-insurance company MBIA , and insurer juggernaut AIG didn't pan out as quickly as he'd hoped, and investors suffered 32% losses for the year while the S&P posted modest 2% gains. Investors fled the fund in droves, sending assets under management plunging.

Yet by 2012, Bank of America had recovered, doubling in value with help from capital financing courtesy of Warren Buffett and rising prospects in the banking sector. Meanwhile, AIG continued its strategy of divesting non-core assets and getting out from under government control. Fairholme's return more than doubled the S&P in 2012. More recently, MBIA's settlement with Bank of America sent shares soaring, allowing Berkowitz to sell out at a large profit.

Admittedly, 2011's massive underperformance did a lot to undermine Fairholme's longer-term track record. The fund's five-year performance now just barely beats out the average for the category. Yet with the rule applying even in an extreme situation, you can more easily see how a fund that just pokes down into the bottom half in performance one year could still put together an impressive track record over time.

Be careful, but don't panicOne thing is true: Higher-cost mutual funds have a greater burden to overcome in producing after-cost returns for their shareholders. That's why in the long run, many index funds beat out actively managed funds. But if you decide passive investing is for you, make sure you do it for the right reasons -- not just because a fund you own didn't manage to top the performance list every single year you owned it.

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Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.

Fool contributor Dan Caplinger owns shares of Fairholme Fund and warrants on AIG and Bank of America. The Motley Fool recommends AIG and Bank of America. The Motley Fool owns shares of AIG and Bank of America and has the following options: long January 2014 $25 calls on AIG. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.